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We have downgraded our recommendation on Hilltop Holdings Inc. (HTH - Analyst Report) to Neutral from Outperform based on weak global cues, amid which we believe expenses and cash outflow are expected to remain elevated. However, a sound capital position along with a risk-free balance sheet has also paved way for the proposed PlainsCapital acquisition and resumption of share buybacks.

Hilltop’s net income for first quarter 2012 reduced to $0.3 million or 1 cent per share from $1.4 million or 2 cents per share in the year-ago period. Earnings also lagged the Zacks Consensus Estimate of 4 cents per share.

Results reflected higher premiums and investment income along with improved net realized gains that drove the top line. However, this growth was substantially offset by higher-than-expected expenses, which in turn hampered the combined ratio and resulted in operating cash outflow and underwriting loss in the reported quarter.

Nevertheless, Hilltop’s vast exposure to the weather-risk prone areas increases the loss and loss adjustment expenses, which also deteriorates its claim ratios, combined ratio and underwriting expense ratios. These factors have not only deteriorated the company’s underwriting capabilities but also the cash position of the company. A substantial decline in operating cash flow at the end of 2011 followed by a continued decline in the first quarter of 2012 further raises caution on Hilltop’s operating leverage.

The insurance industry is highly competitive and has historically been characterized by periods of significant price competition. The industry has been facing falling prices for almost four years now, especially for the Property & Casualty segment, due to the global market downturn that had peaked a couple of years ago, and this is also affecting Hilltop substantially.

On the flip side though, Hilltop’s balance sheet remained risk free and fairly liquid despite the challenging operating environment. Moreover, Hilltop’s investment, debt and securities along with its subsidiaries are well poised in the market owing to their superior financial strength and credit ratings. This leaves excess capital and ample scope for more meaningful acquisitions and alliances for the company’s long-term growth.

Complementing its inorganic growth and expansion strategy, Hilltop intends to buy whole of PlainsCapital for about $537 million, as announced in May 2012. We believe the acquisition is affordable and aligned to Hilltop’s growth goals, thereby fortifying the company’s market position in the primary operating markets of Texas, Oklahoma, Georgia, Tennessee and Arizona. The deal is subject to customary approvals and is expected to be culminated by the end of 2012. Moreover, Hilltop’s healthy capital deployment strategy is also reflected from the new $100 million share repurchase program announced in November 2011, which bodes well for imbibing confidence in the shareholders.

Overall, Hilltop’s future performance will largely depend on the prudent deployment of its reserves. Thus, we expect the company to grow and evolve in the upcoming quarters by expanding its operations, which should further drive the anticipated upside in the stock. Nevertheless, we wait for the clearance of the smog and for gaining better visibility, which justifies our current Neutral outlook.

Weighing all the pros and cons, the Zacks Consensus Estimate is currently pegged at a loss of 11 cents per share for second-quarter 2012, lower than the loss of 23 cents per share in the year-ago quarter. Meanwhile, Hilltop is expected to report break-even figures per share in 2012, up from a loss of 12 cents per share in 2011. Hilltop primarily competes with PennyMac Mortgage Investment Trust (PMT - Snapshot Report) in its insurance space.

Additionally, the quantitative Zacks Rank for Hilltop is currently #4, translating into a short-term Sell rating, while the long-term stance remains Neutral.

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